Why the FED rate cuts are not indicative of lower consumer rates

The federal reserve rate cuts might make you feel better about getting a loan, but for most people, the rate cuts do not dramatically impact consumer level loans.

Banks operate on a very thin margin between the Federal Reserve rate and the amount that borrowers pay to lend. If the banks are borrowing at 3%, the consumer will commonly receive a rate of 6% to 7% on a home loan. The difference is what the banks earn by borrowing low and lending high. Unfortunately, even when the Federal lending rates drop, banks are unlikely to continue lowering rates.

When you borrow from a bank with a fixed loan, you are practically getting money from a middle man. Although you may have borrowed at 7% on your home, the bank will often procure a loan from the Federal Reserve at 4%. The banks loan is locked in at 4%, just as yours is fixed to 7%. If rates were to skyrocket, you would get the same rate and the bank would still have a line of credit from the Fed at an equally lower rate.

Banks accept a high level of risk for their lending practices, which happens to be the primary why the rates are not dropping. If the bank is unable to collect money from the borrowers, it still has to make payments to the Federal Reserve for their loan. The banks like to have a comfortable margin to accept the risks of people going under. In effect, loans operate just like a insurance policy. The extra 3-4% over the Fed rate allows the bank to lend money while still staying profitable.

Just as gas prices are quickly to go up when wholesale prices go up, and slow to drop when the wholesale rate drops, banks operate in the same fashion. The extra that you pay protects them when people can no longer make payments. It is unfortunate, but the rate drops are more likely to help banks than they are to help consumers. At extremely low rates, banks would rather invest the money themselves in other things than give $100,000 to the average homeowner for a new home.